U.S. financial-services stocks have come a long way since their 2008-2009 meltdown, which dragged the rest of the market down with them. But unlike the S&P 500 as a whole, the financial sector is nowhere near record territory at its current level. This suggests that there continue to be opportunities within the sector for above-market returns.
Up roughly 60% over the past two years, the S&P 500's financial-services sub-index has been the second-best-performing sector during that period. Even so, this has not been nearly enough to recoup all of the losses incurred when the sector plunged more than 80% from its June 2007 peak.
The financials sub-index, which recently surpassed 300, remains far below its record high of more than 500 that it reached seven years ago. By comparison, the S&P 500 recently reached 2000 for the first time in history, having roughly tripled since its March 2009 bear-market low of 676.
Though the landscape for financials has changed quite drastically since 2006-2007, the sector remains a mainstay of any diversified U.S. stock portfolio. Representing approximately 16% of the S&P 500, financial services is the second largest sector weighting, behind only information technology. Moreover, the weighting of financials is up sharply since March 2009, when it had shrunk to just 8.9% of the S&P 500.
However, since there has been a wide range between the best-performing and worst-performing stocks in the sector, prudent stock selection is warranted.
Wells Fargo & Co. WFC, the highest weighted financial stock, has also been one of its best performing since the March 2009 market bottom. It has returned 128% -- or 23% compounded annually -- over the last four years. At US$52 as of Oct. 3, 2014, the stock has staged a spectacular rebound from US$7.30 in March 2009, far surpassing its pre-crisis peak of US$34.80 in September 2008.
Wells Fargo stock looks particularly attractive to investors seeking dividend growth, attributable to the company's decision to raise its quarterly dividend to 35 cents this year compared with five cents in 2010.
The financial sector's second-largest weighted constituent is Berkshire Hathaway Inc. BRK.B. From a pre-crisis adjusted price peak of US$95.90 in February 2008, shares of the holding company that Warren Buffett built plunged to US$46 in March 2009, losing more than half their value. Much like Wells Fargo, Berkshire Hathaway has rebounded to new highs.
The stock is hovering at around US$139, which is under Morningstar's fair-value estimate of US$150. Under Buffett's leadership, Berkshire's book value has grown at an average rate of 19.7% compounded annually from 1965 to 2013. The stock is one of the best performers in the past year among large-cap financials, making it an appealing pick for investors who prefer to own best-of-breed companies.
Not all financial stocks have been as resilient. Consider, for example, Bank of America Corp. BAC and Citigroup C, also among the largest stocks in the sector. Both companies were significantly restructured and recapitalized, so they are very different entities from what they were seven years ago. CITI and BAC have returned 8.3% and 5.6% compounded annually, respectively, over the last four years, compared with the S&P 500's 16.3%. Neither has recovered to its pre-crisis peak.
Discover Financial Services DFS is a very attractive investment choice among large-capitalization financial companies. It's forward price-to-earnings ratio is 11.3 times versus 14.5 for the median U.S. financial company, while its book value is projected to expand by 19% next year compared to just 6% for the sector. DFS has returned 16.2% compounded annually over the last four years.
Meanwhile, Goldman Sachs Group Inc. GS, another prominent survivor of the financial crisis, also seems to have good potential. Its price to trailing earnings ratio of 10 times should appeal to value-oriented investors. The company beat earnings forecasts when it last reported its earnings on July 15, which prompted the analyst community to revise their fiscal earnings estimates upwards. This bodes well for an expansion of its P/E ratio.
